Penn Company, a small company following accounting standards for
private enterprises, is adjusting and correcting its books at the end of 2011.
In reviewing its records, it compiles the following information.
1. Penn has failed to accrue sales commissions payable at the
end of each of the last two years, as follows:
Dec. 31, 2010………… $3,500
Dec. 31, 2011 ……….. $2,500
2. In reviewing the December 31, 2011 inventory, Penn discovered
errors in its inventory-taking procedures that have caused inventories for the
last three years to be incorrect, as follows:
Dec. 31, 2009 ………………. Understated $16,000
Dec. 31, 2010 ………………… Understated $19,000
Dec. 31, 2011 …………………. Overstated $ 6,700
Penn has already made an entry that established the incorrect
December 31, 2011, inventory amount.
3. In 2011, Penn changed the depreciation method on its office
equipment from double-declining-balance to straight-line. The equipment had an
original cost of $100,000 when purchased on January 1, 2009. It has a 10-year
useful life and no residual value. Depreciation expense recorded prior to 2011
under the double-declining-balance method was $36,000. Penn has already
recorded 2011 depreciation expense of $12,800 using the
double-declining-balance method.
4. Before 2011, Penn accounted for its income from long-term
construction contracts on the completed-contract basis because it was unable to
reliably measure the degree of completion or the estimated costs to complete.
Early in 2011, Penn’s growth permitted the company to hire an experienced cost
accountant and the company changed to the percentage-of-completion basis for
financial accounting purposes. The completed-contract method will continue to
be used for tax purposes. Income for 2011 has been recorded using the
percentage-of-completion method. The following information is available:
Pre-Tax Income
Percentage of completion Completed
Contract
Prior
to 2011 150,000 105,000
2011 60,000 20,000
Instructions
(a) Prepare the necessary journal entries at December 31, 2011,
to record the above corrections and changes as appropriate. The books are still
open for 2011. As Penn has not yet recorded its 2011 income tax expense and
payable amounts, tax effects for the current year may be ignored. Penn's income
tax rate is 40%.
(b) If there are alternative methods of accounting for any items
listed above, explain what the options are and why you chose the particular
alternative.
(a)
1. Retained
Earnings [$3,500 X (1 – 40%)]. 2,100
Income
Tax Recoverable / Payable....... 1,400
Sales
Commissions Payable.......... 2,500
Sales
Commissions Expense.......... 1,000
2. Cost
of Sales ($19,000 + $6,700)....... 25,700
Income
Tax Payable................. 7,600
Retained
Earnings [$19,000 X (1 – 40%)] 11,400
Inventory.......................... 6,700
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Income Overstated (Understated)
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2009
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2010
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2011
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Beginning inventory
Ending inventory
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$(16,000)
$(16,000)
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$16,000)
(19,000
$ (3,000
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$19,000
6,700
$25,700
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3. Accumulated
Depreciation—Equipment..... 4,800
Depreciation
Expense............... 4,800
*Equipment
cost...................... $100,000
Depreciation
before 2011........... (36,000)
Carrying
amount.................... $ 64,000
Depreciation
to be taken ($64,000/8) $ 8,000
Depreciation
recorded............... 12,800
Difference.......................... $ 4,800
4. This
is a change in circumstances as the company couldn’t reliably measure the
revenue in past years and now it can. This would be accounted for on a
prospective basis. For example, if the type of the contracts that the company
undertakes has changed, thereby allowing the company to estimate the degree of
completion, this situation could be the result of transaction that differs
substantially from those that were previously occurring. In this case, the new
accounting policy (applicable to the new type of contracts) would be applied on
a prospective basis
(b) In
the case of long-term contracts, management may not be able to recreate the
estimates required to adjust comparative financial information or to
recalculate the effect on opening retained earnings for years before 2011.
A
change in accounting policy should be applied on a full retrospective basis
except where it is impracticable to do so.
Alternative
methods of accounting for Situation 4 would include treating the change as a
change in accounting policy with full retrospective application if the effect
on specific prior periods presented for comparative purposes can be determined.
Situation
4 could also arguably be considered a change in accounting policy under GAAP
rather than as the application of a policy to new circumstances. If this was
the case, it would likely be an error correction since if you could have
measured the revenue appropriately under the percentage of completion you would
not have been following GAAP if you used completed contract (since you should
have been using percentage of completion).
